Question

An American firm borrows Euro 1 million for one year at an interest rate of 2.5%. The Euro is expected to appreciate by 2% over the life of the loan. The American's effective cost of borrowing is approximately:

a. 2.5%

b. 4.5%

c. 2.0%

d. .5%

Answer 1

We have a borrowing of 1 million Euros. We will convert $ to Euros and pay at time of maturity. Simply speaking Euro is our liability, and if liability appreciates, that means more needs to be paid for the liability.  As Euro appreciates, that means dollar depreciates, hence more dollar needs to be given to satisfy same amount of euros. Hence appreciation of Euro effectively increases our borrowing cost.

Effective Cost of Borrowing = Rate of Interest + Currency Rate fluctuations

= 2.5 + 2 = 4.5%

Hence, effective cost of borrowing is 4.5% Correct option b